Manipulate This - What Really Drives Global Capital Flows
I am generally a tolerant guy, but when it comes to a debate on international capital flows I am a raving lunatic. I have no time for amateurs, and it is my clear impression that president Trump’s trade advisors, and those who agree with them, are just that. You need to understand where I am coming from, though. Specifically, you need to read my two essays about QE, population ageing and the global paradox of thrift. Here is a summary if you don’t want to read the whole thing; read it carefully.
"If more and more economies are now faced with a negative natural rate of interest it means that (desired) savings will exceed investment even with ZIRP. This has crucial implications for global capital flows. You only need rudimentary algebra to see this in the context of basic national accounting. If S>I it can only mean that the current account is positive in an open economy and this is difficult to prescribe as a universal growth strategy since you need someone to run the deficits.”
(…)
"The costs, or negative externalities, are financial instability. Volatility will remain very low for extended periods, only to rise rapidly as capital flows back to the savers in times of crisis. Global carry trade flows and the associated booms and busts provide ample evidence of this.
The next obvious question is what to do about it? We don't have a global social planner to mitigate the costs of excess savings but discussions about whether China is a "currency manipulator” and the G7 push, in 2006, for the BOJ to join Trichet and Bernanke in the "great interest rate normalisation" are both examples of how this externality can lead to conflict. How long will it take now, for example, before the U.S., the U.K. etc start probing the Eurozone about whether QE and ZIRP are a necessary combination in a world where the German economy are accelerating rapidly with a labor market that has never been tighter?”
The final bit is obviously close to where we are today, and it wasn’t really difficult to see that this is where we would end up. I can’t force you to agree with my theory on international capital flows, but I want to make it clear that if you don’t, I think you will be wrong about a lot of the assumptions and predictions you make from this point on. We need to get the basics right.
It won’t surprise you then to learn that I am pretty unimpressed by the trade policy discourse–we don’t have any actual policies yet—of the new U.S. administration. The U.S. runs its largest bilateral trade deficits with Mexico, Germany, Japan and China and the U.S. leadership has taken potshots at all of them [1].
Specifically targeted tariffs are possible, although unlikely I think. The only concrete policy proposal we have so far is the idea of a border tax. The stylised idea, as far as I can see, is to tax imports by 20%, cut the corporate tax from 35% to 20%, and effectively exempt exports from said tax. We can think about it as a VAT on imports. That said, I have read a enough about this to convince me that the administration does not know how it is going to look, and economists generally have no clue about the effects. I am not saying that we should know; it is simply a question of a lot of moving parts and we don’t know how prices and volumes will have adjusted once the dust settles.
It's difficult to see how the U.S. can square the circle on trade, the dollar and its growth ambitions. Tariffs/less trade openness, fiscal stimulus/deregulation, tighter monetary policy equal an inflation bonfire in the US and higher yields; hence the idea of a significantly stronger dollar. Mr Trump's issue as far as I see it is that he can't succeed without importing foreign savings from abroad via a higher external deficit. Categorically, however, he does not want that, which is why the nexus between reflation and the possibility of a much stronger dollar is so difficult to get a handle on. In an earlier post, I identified three potential scenarios.
1) Raging USD bull, higher global growth. In this scenario, Mr. Trump's policy mix emphasises domestic fiscal stimulus, but a relatively benign clampdown on free trade if any at all. The Fed raises rates, but the U.S. economy continues to power ahead by sucking in savings from abroad. The USD appreciates, the U.S. c/a deficit widens, and we all live happily ever after, at least for a while.
2) Stronger USD offsets aggressive border adjustment tax. In this scenario, the border tax adjustment happens, but a stronger dollar offsets the impact on the U.S. trade deficit. The key changes in this scenario would be within the U.S. economy and the economies of its closest trading partners.
3) Weaker USD with an aggressive border adjustment tax. In this scenario, Mr. Trump goes full retard on the border adjustment tax/free trade clampdown. The USD dollar depreciates because markets perceive it to be adverse to U.S. economic growth. Domestic inflation rises sharply, the U.S. economy slows and the trade deficit narrows. The rest of the world is pulled down with the U.S. economy and a global recession ensues.
I put my bet on a half-way house between number one and two. Let’s do the math, because I am not sure that Mr. Navarro and his people have. You're the global FX reserve currency and biggest economy in the world, and you spend more than you earn; the U.S. runs a budget and current account deficit of 2.7% and 3.2% of GDP respectively. It stands to reason that you run your largest trade deficits with the great production hubs of the world; China, Japan, Germany and Mexico (via NAFTA).
Now you want to tax the goods these guys sell you, but common sense suggests that you can’t assume that these goods can be substituted in the U.S. at the same price? In other words, if US consumers want to continue their “normal spending” patterns—which involves spending more than they earn—they will have to pay up. So you end up taxing yourself via higher inflation. Many economists have objected to this line of reasoning; the dollar will go up compensating for higher import prices they say.
But if it does that, the external deficit likely will increase. No one, for example, has talked about the import multiplier. If you boost taxes on imports to fund tax cuts, you could just see that money flow out via a wider trade deficit. Again, when I hear Mr. Navarro speak, I am honestly worried that he doesn’t understand the dynamics here. You can go round and round in circles forever.
I accept the notion that the policies are designed in part to nurture exports, via tax exemption, but I don’t see how that changes my fundamental point. A U.S. economy with a balanced trade external balance means an economy with lower growth and investment. And if the government responds with a much higher budget deficit, interest rates would increase a lot. What would that do to Trump’s hope of a domestic economic revival?
Remember the demand side
The idea that countries with external surpluses are exploiting the rest of the world is getting traction even with analysts and economists that I normally consider to be smart. This is deeply concerning, because it is, in the main, nonsense on stilts. Consider the intra-European case study of U.K. and the Eurozone, which is relevant in light of the U.K.’s decision to leave the EU. The Eurozone runs a larger trade surplus with the U.K. than it does with the U.S., which is a remarkable fact when you consider the relative sizes of the U.S. and U.K. economies. Are we really to believe that this imbalance is solely the fault of excess savings in the Eurozone and Germany? Is it really the Europeans’ fault that the U.K. economy borrows 8% more than it earns every year, of which 5% is the current account deficit?
It is amazing in this context to consider that despite the EURGBP racing towards parity since the referendum the response from the U.K. economy to this repricing in relative prices so far has simply been to borrow more to keep buying all those nice and flashy EZ automobiles. In fact, as a UK resident I sometimes feel as if I am living in the middle of failed economic policy experiment. The government has been showering me with tax cuts every year since 2011, even as the external deficit has ballooned. This is despite the fact the EZ economies emerged from the panic in 2012 with a big increase in the propensity to save in order to prevent foreign capital from ever having a say in domestic yields again.
Maybe the U.K. government couldn’t have anticipated this, but shouldn’t they have been trying to lean against the surge in domestic demand? Austerity is wrong I hear you shout, but don’t think for one minute that we haven’t seen austerity in this country. Most of it, however, has been levied on spending cuts rather than via higher taxes. Cynically this makes sense, the Tories had an election to win. In this tax cuts, help-to-buy schemes etc were needed. But economically, I am not so sure really.
I fully concede that Germany’s external surplus, in this respect, has been boosted way beyond normal levels. Germany ran a substantial surplus before the ECB let fly with QE and negative interest rates; it has now grown to monstrous proportions. The policy proposal, it seems, is for Germany to engage in fiscal stimulus. How dare they run a balanced budget is the common refrain. Economists who make this argument have, as far as I can see, not taken the time to have a close at the German economy. If they did they would realise that it is already firing on all cylinders. Private consumption and investment is strong, unemployment is at record lows, construction in housing and mortgage lending are surging. And the icing on the cake; government spending is rising at a pace not seen since reunification, due to higher than expected tax revenues and low interest payments. To call for fiscal stimulus in this context to lower an external surplus—in effect asking Germany to increase domestic demand to facilitate high growth elsewhere—is bonkers in my view. Despite my reservations it seems that Germany is wobbling under the pressure; the 2018 draft budget is pencilling in a small budget deficit.
This policy prescription ignores two things. Firstly, it neglects the fact that what we’re seeing in Germany at the moment likely is highly unusual. German is the second most rapidly ageing economy in the world, and the state has substantial contingent liabilities. There will be plenty of time later for Germany to use any fiscal room to help growth. Pro-cyclical fiscal policy in Germany makes little sense. Secondly, the situation in Japan suggests that fiscal stimulus won’t do much. Abenomics is fiscal stimulus on speed, and Japan still runs a current account surplus. Incidentally, Japan is the most rapidly ageing economy in the world. Do you see the pattern yet?
One by one, the global economy's mature ageing countries are converging on the same growth path of a high external surplus and rising net foreign assets. Trying to prevent that from happening in my view is a bit like trying to empty the Atlantic Ocean with a tea spoon.
Eureka! Europe should devalue
A rather sinister twist in the criticism of Germany’s external surplus is the idea that Germany is exploiting the Eurozone to its advantage. It is inferred here that it would be best for everyone involved, and the world, if the Eurozone were dismantled. The naivety is breathtaking in my view. The new deutschmark clearly would revalue immediately after a break-up of the Eurozone, but do the proponents of an EZ break-up really believe that the new Bundesbank would run a hard currency/high rate policy? I think this is unlikely. Just like Switzerland, they would be forced to follow the policies of its closest neighbours, which presumably would want to devalue their currencies vis-a-vis the rest of the world to gain an advantage. In effect, the thinking in the U.S. administration appears to be that an EZ break-up would lead to a stronger dollar because Germany would revalue, but that is a tenuous conclusion. I think the net result would be weaker EU currencies, against the dollar, across the board, eventually at least. Germany, I think, would slowly but surely move towards a similar position as Japan. To put this in a language that everyone can understand; the Bundesbank would become every bit as accommodative as the ECB and BOJ are today.
Then there is the question of Italy, Spain, Greece and Portugal. Wouldn’t they be better off if they weren’t tied to a hard currency such as the euro? I beg to differ. These countries can hardly get a better friend than Mr. Draghi. Despite the differences between EZ economies they all share a number of characteristics, which are converging over time. They all have rapidly ageing populations, they have public pay-go systems, and generally generous welfare states. They probably all need to run external surpluses and have low interest rates to survive in the long run. Just think about the privilege of being able to face such challenges with the ability to borrow and spend in the same currency as Germany. If they parted ways, many EZ economies would be facing the unenviable prospect of having EM-like external funding conditions with Japan-like demographics. That is a bad combination! Sticking together in the EZ is their only chance in my view.
This is where I face the strongest opposition. My impression is that a consensus is slowly emerging among economists that the major EU economies would be better off with their own currencies. In a discussion on Twitter last week, I opened Pandora’s Box by suggesting that Matthew Klein was wrong in his comparison between Greece and number of emerging economies. The inference by Matthew as far as I can see is that Greece would have done much better since the financial crisis if it had not in the Eurozone. That question is impossible to answer, but my gripe mainly is that Matthew compares Argentina, Brazil, Indonesia, Thailand, and Turkey with Greece. That’s like comparing apples with pecan nuts, mainly due to the sharply different demographic profiles. Why not look to Eastern Europe where demographics also are horrible, and where many economies, even with their own currencies, haven’t done well since 2008.
I concede, though, that the situation in Greece is a particular kind of horror story, and one which can’t go on. It is interesting here that the Greek economy actually was enjoying a nice cyclical recovery going into 2015, before the game of chicken between the EU and Syriza left the banking system and economy in tatters. The result is that Greece, since 2015, has had none of the disadvantages of EZ membership—no QE, no collateral for TLTROs etc—but plenty of the disadvantages in terms of fiscal control from the IMF and Eurogroup. Something has to give here, and I for one am not looking forward to another round of painful tit for tat between the Greek government and the EU.
I don’t believe, however, that spiting Germany and northern Europe by devaluing is the way to go. But in the end, the people of Europe will decide. If populations in France and the periphery want their currencies back, the governments should deliver just that. Despite the meme of the EU/EZ as a destroyer of sovereignty, every country can decide for itself. What could the rest of the EU economies do if the Greek government informed the world that it was going back to the drachma? Very little is my guess. But herein also lies the rub. No one really wants to leave the EZ and the EU. What unites the sceptical countries, whose politicians and populations are increasingly against the idea of a united Europe, is that they want to game the system to their advantage. In Greece’s case, debt relief/QE within the Eurozone would definitely be the best option. If only they wanted to leave, negotiations could be over in an afternoon, or thereabouts.
A related argument here is that if the Eurozone ruptured the global savings glut would surge. It would only take one of the big economies to devalue for all the rest to follow suit. Money printed in the Eurozone would shower the rest of the world, leaving central banks such as the Fed, the BoE, BOC, RBA and their EM brethren with the conundrum of whether to raise rates, risking to suck even more capital in. In other words, the U.S. and, other would-be destroyers of the euro and its external surplus, should be careful what they wish for.
So what’s your solution then?
I have ranted but I haven’t provided any solutions. That’s not constructive. It is one thing to say that the world is converging on a state in which more and more economies will tend to “prefer” external surpluses. But in the extreme that simply doesn’t work, so what do we do? First of all, there is plenty of capacity out there if you put on the optimist's cap for a minute. Emerging/frontier markets are much more balanced in a demographic sense and assuming a benign growth path—i.e. no rent seeking dictators or wars—these in time will be able to accommodate surpluses in the OECD. This is a big assumption of course, and boom/bust cycles won’t go away, but it’s a start.
Secondly, let’s try to look at this from the perspective of the US/UK, and others in their position, with the assumption that external surpluses elsewhere are structural in nature. In the initial remarks above, I asked what a “social planner” would do. For starters, he would “allow" the deficit economies to tax part of these structural surpluses elsewhere. I actually don’t think that is unfair at all. The key is what they use the “proceeds” for. If you just go away and lower taxes on domestic spending and investment, you end up sucking in the surpluses anyway via higher spending. But what if you used the revenue to run a counter cyclical fiscal surplus and/or use the proceeds for productivity enhancing investment. I have no qualms with Mr. Trump’s plans to boost infrastructure spending. But how about using some money on re-education and training of the workforce too?
In short; I am suggesting that economies that have external deficits, due to the structural propensity of other economies for external surpluses, should run counter cyclical fiscal surpluses partly financed by taxing imports.
The only real alternative is for the economies with external deficits to curb the free flow of capital. In short, they can move to prevent foreign money from flowing in via capital controls. If they do, though, they must also correct their external deficits or, more specifically, curb their enthusiasm for spending more than they earn. The ability to run sizeable twin deficits without rapidly rising inflation or higher interest rates is only possible due to the ability of countries to smooth consumption/investment via the external balance. If they opt for a closed economy savings must equal investment at all times. I am not sure this is would allow Mr. Trump to get what he wants, at the speed that he wanted it.
Mr. Navarro will continue to moan about bilateral the U.S. economy's trade deficits, Mr. Trump will nod approvingly, and I fear more otherwise intelligent economists and commentators will be sucked in. It's sad state of affairs if you ask me.
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[1] - Although the White House visit by Japanese Prime Minister Shinzo Abe appears to have gone well.